What’s the difference between tulips, the South Sea Company, stocks in the Roaring Twenties, Japan’s Nikkei in the '80s, the NASDAQ '90s, the recent housing boom, the current price of gold—and bonds? All of the above except bonds had some measure of euphoria—or “animal spirit,” as some like to say—attached to them. Bonds, on the other hand, have simply been a bastion of safety. However, given the massive amount of investor capital which has flowed into fixed income offerings, what will happen when the music stops and interest rates reverse course? How much could investors lose when rates rise? The answer is, it depends. It depends on the type of bond, their coupon and maturity, their credit quality, how you own them and the degree to which interest rates rise.
Before we dive into these subjects, let’s take a step back and discuss our current economic landscape. The health of the economy is a critical factor in determining interest rates and the direction of interest rates has a profound impact on the performance of fixed income issues.
The Challenge of the Fed
The Fed controls our nation’s monetary policy through the Federal Open Market Committee (FOMC). The FOMC’s mandate is to provide for stable prices and economic growth. Although fiscal policy, which is established by Congress, is a large determinant in economic performance, our focus will be on monetary policy.
The Fed has various tools to accomplish its mandate which include controlling the money supply, setting the discount rate and setting bank reserve requirements, to name a few. However, since the onset of the Great Recession, the Fed has exhausted much of its ammo as interest rates and bank reserve requirements are already at or near zero. Many believe that the Fed’s “zero interest rate policy” is designed to push investors out of cash and into riskier assets. In any event, what arrows are left in the ol’ quiver? Not much except expanding the money supply, which brings us to QE2.
The Fed and QE2
St. Louis Fed President James Bullard said in a CNBC interview in mid-2010 that the prospect of long-term deflation is real. Hence, the Fed has been doing everything it can to avoid this. Several months ago, I read a paper written by Fed Chair Bernanke in 1999 while at Princeton. The paper discussed the Japanese deflationary crisis, which has now been entrenched for over 20 years, and what Bernanke would have done to resolve it. As I read, I compared his recommendations to the Bank of Japan and his actions here at home. The list was strikingly similar. Then it hit me—I was reading his playbook. However, there was one item on the list that Bernanke hadn’t addressed as of that time: devaluing the dollar. Weakening the dollar creates the illusion that prices are rising. This is because when the dollar is weak, it takes more to buy the same goods and services. A weak dollar also makes imports more expensive—which is inflationary—and attracts foreign capital. The United States depends on foreign capital to buy U.S. government bonds which help finance government spending. Weakening the greenback would also allow us to pay down our debt with cheaper dollars. This is what is referred to as monetizing the debt. QE2 is designed to do exactly that. However, many other nations are also devaluing their currency, and since the value of a currency is measured in relative terms, our dollar has actually been strengthening recently. In any event, inflating the economy and stimulating demand is the Fed’s goal and QE2 is the tool.
The Consumer and Demand
The growth of the economy is best measured by gross domestic product (GDP). There are four components to GDP: consumer spending, business spending, government spending and net exports. Consumer spending accounts for approximately 67% of GDP.
Consumers took a particularly nasty hit on multiple fronts with the recent financial meltdown as they watched the value of their homes plummet and their financial assets erode. This created a great deal of fear and, to a large extent, the consumer is still on the sidelines. Moreover, nearly 10% are unemployed. Business and industry is another part of GDP and although businesses have cleaned up their balance sheets (except for those holding a glut of high-risk mortgages), their reliance on the consumer cannot be overstated. Also, with demand weak and an uncertain tax environment, businesses have been somewhat reluctant to hire. Government, another component of GDP, has shown no timidity to spend, but we’ll leave that for another time. Finally, a weak dollar would boost net exports which would add to GDP.
To boost GDP and avoid a deflationary scenario, the all-important consumer needs to start spending again. However, due to a record number of defaults, lenders have tightened their credit standards. Even though government has been lambasting lenders, should they lower their standards when that’s the very thing that got them in trouble? In practice, lenders shouldn’t be strong-armed into making loans to high-risk borrowers. In my opinion, a battle is raging between government and the private sector, especially banks. The government is attempting to punish banks by adding to their regulatory burden. The effects of this, however, will be felt by the consumer as banks will simply pass on these additional costs. Another illustration of unintended consequences? You decide.
So the challenge remains how do you stimulate demand and get the consumer back in the game? Inflate prices through a weaker dollar, that’s how. If consumers believe that prices will fall, they’ll wait to buy. If, on the other hand, they believe prices will rise, they will buy now rather than pay a higher price later. Of course confidence, which is low, plays a major role here. Now that you know my view, let’s turn to a couple of bond managers for their analysis.
A Word from a Few Experts
I recently spoke with Ken Volpert, manager of the Vanguard Inflation Protected Bond Fund (VIPSX) and head of the taxable bond group at Vanguard. He believes that interest rates will rise over the next year and GDP will exceed 3% by the last half of 2011. His greatest concern is the fiscal austerity measures being implemented globally and here at home by state and local governments. States have a mandate to balance their budgets and so mandatory cuts appear inevitable. He also believes the U.S. government must address its longer term structural problems, but this author is not optimistic about that. His advice is to shorten maturities to less than five years.
I also sat down with Jeff Tanguis, manager of the Hancock Horizon Strategic Income Bond Fund (HHBAX). Mr. Tanguis and I discussed the Fed’s manipulation of the dollar through QE2 and how interest rates are artificially low. He believes that rates will be higher a year from now, but also expects a general rise over the next several years. His major concerns include a sluggish economy for years to come, high unemployment, and the possibility of stagflation like we saw in the ‘70s.
With this economic backdrop, let’s turn our attention to the topic of fixed income securities.
As I mentioned earlier, investors have flocked to this ‘safe’ asset class en masse in recent years. Are the best times for bond investors in the past? What are the risks to investors in this asset group?
In general, duration is a measure of the sensitivity of a bond’s price to changes in interest rates and is expressed as a number of years. Although there are several variations, or types of duration, our primary focus will be on Macaulay’s Duration.
Macaulay’s Duration was named after Frederick Macaulay, who earned a Ph.D. from Columbia University, and measures the weighted average maturity of a bond. Macaulay’s Duration may be further defined as the point at which the weighted maturities reach equilibrium. Think of it in terms of a see-saw. The see-saw, which is supported by a fulcrum, will be parallel to the ground when the weight is equally distributed on both sides. A typical bond will have a series of cash flows consisting of principal and interest over its term with the majority of its payment occurring at maturity. Therefore, the duration of a bond without periodic payments will always be higher when compared to a bond with a series of cash flows, assuming their maturities are identical. Let’s look at an example. Consider a 10-year zero-coupon bond which is purchased at a discount and matures at par value. Hence, because there are no payments until maturity, its duration would be equivalent to its maturity of 10 years. Now let’s assume a 10-year bond with a 6% coupon, paid semi-annually. In this case, the duration would be 7.66 years due to the fact that the investor will receive payments prior to maturity. At the 7.66 year mark, the investor would have received roughly half of his expected payment.